Could Volker Rule Be a ‘Stealthier’ Way to Cut U.S. Debt?

As Washington’s infamous budget battles and government shutdowns show, resolving the U.S. debt overhang by cutting federal spending and raising taxes is a colossal political task.

That’s why, according to Harvard University economist Carmen Reinhart, U.S. officials are resorting to financial regulation and monetary policy as an effective way to pare down the country’s public obligations.

“The relatively ‘stealthier’ financial repression tax may be a more politically-palatable alternative,” Mrs. Reinhart said a 2011 paper on how rich countries liquidate their arrears.

Mrs. Reinhart, writing with former International Monetary Fund economist Belén Sbrancia, predicted that authorities in rich economies would increasingly use their powers to channel funds to their governments as a way to help clear their mountainous debts, a term called “financial repression.”

After World War II, advanced economies were able to slash massive debt stocks by controlling cash flows, depressing interest rates and crafting new financial regulations that created captive demand for their sovereign bonds. With inflation as an ally, the U.S. and the U.K were able to cut government debt at a rate of 2%-3% of gross domestic product a year, or 20%-30% of GDP a decade.

But “financial repression is by no means passé,” especially in the postcrisis debt-laden environment, the economists argue.

One form of financial repression is a reduction in nominal interest rates by central banks. The Federal Reserve, the European Central Bank and the Bank of Japan say their interest rate cuts were necessary to spur growth and drive their economies out of economic quagmire. But incidentally, depressing rates reduces the costs governments pay on their debt, which in turn cuts national deficits. If central banks can stoke inflation without creating asset bubbles or fueling a damaging rise in consumer prices, those easy money policies can also reduce the value of their debt stocks through negative real interest rates.

But financial regulation can also create a captive markets. For example, The banking regulations published by the European Union in July are meant to require bigger emergency cash reserves. Deeming government securities zero-risk, high quality assets, however, the rules support demand for sovereign bonds. (And that’s despite the fact that some euro zone sovereign debt has proven a pretty risky bet.) Another is the Fed’s October ruling to bolster liquidity at large financial institutions. The new regulation requires minimum holdings of “high quality,” assets that can quickly be converted into cash; government debt fits the bill.

And now, whether intended or not, the Volker rule is another form of financial repression, says Mrs. Reinhart.

The new regulations are meant to rein-in Wall Street risk-taking, one of many rules drafted after the 2008 global financial crisis. They prohibit banks from using their own cash to profit from trading a whole host of stocks, equities and derivatives.

But some assets were ruled exempt, including government debt.

That means capital that would have been used to buy corporate debt, for example, is now more likely to be employed in purchasing government debt.

The three main agencies responsible for crafting the new regulations with particular oversight of Treasury markets — the Fed, the Commodities Futures Trading Commission and the Office of the Comptroller of the Currency — declined to comment for this article.

But in their final rule, the agencies said the exempted trading of government obligations “will continue to provide significant support and liquidity to the U.S. government and agency security markets.”

They also said that trading of Treasury futures “is essential to ensuring the continued smooth functioning of market-making related activities in Treasury securities.”

The agencies also exempted trading of other countries’ debt, taking into consideration warnings from foreign governments such as Canada, Germany, Luxembourg, Japan, Australia, and Mexico. Those counties specifically requested an exemption for trading in obligations of their governments, arguing that an exemption was necessary “to maintain and promote financial stability in their markets.”

Regulators took into account concerns that if U.S. didn’t exempt sovereign debt of foreign countries, “it could critically impact the functioning of money market operations of foreign central banks and limit the ability of foreign sovereign governments to conduct monetary policy or finance their operations.” (See page 374)

In a more recent paper with Harvard colleague Kenneth Rogoff, Mrs. Reinhart challenges assertions by European and U.S. officials they can cut their deadly debt overhangs largely through fiscal belt-tightening and growth.

“This claim is at odds with the historical track record of most advanced economies, where debt restructuring or conversions, financial repression, and a tolerance for higher inflation, or a combination of these were an integral part of the resolution of significant past debt overhangs.”

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